9/27/13 – The Government Shutdown, the Debt Ceiling, and the Markets

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 27, 2013 10:22:00 AM

and tagged Fiscal Cliff, Debt Crisis, Politics and the Economy

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I have to be honest: I’ve been putting off writing about this for the past couple of days, for both good and bad reasons. One good reason is that, really, there hasn’t been much news. Congress is playing games, everyone is shouting at each other, and nothing is getting done. The other good reason is that there’s not much we can do to prepare, given the level of uncertainty that prevails. No news, no action items, no need to comment.

The bad reason I have for putting this off is that, quite frankly, it’s depressing. We’ve been through this before, in both 2011 and 2012, and the fact that we’re going through it once again is just ridiculous. Be that as it may, though, here we are, so let’s deal with it.

First, the frame. We have two pending deadlines here. The first, at the end of September, is the expiration of the U.S. government’s funding authority. If Congress does not pass, and the President does not sign, some form of budget or continuing spending authorization, all nonessential services of the federal government will be shut down as of the end of September 30. The Washington Post offers a good guide to the details of the shutdown.

Big picture, what does this mean? Economically, the effects would be similar in type, if not necessarily in magnitude, to those of the sequester. Federal spending cuts slow the economy by diminishing overall spending. With 800,000 workers losing their paychecks for a period of time, consumer spending would get hit, any projects that require the government to cut checks would get hit, and the economy overall would take a hit. Beyond that, the damage would depend on the length of the shutdown—the longer, the worse.

There would be other damaging effects, of course, but the direct economic impact would likely be relatively modest unless the shutdown lasted for months. In 1995–1996, a shutdown lasted for five days in November and 21 days in December and January; the furloughed workers were awarded back pay afterward, which limited the ultimate damage.

A shutdown itself, if resolved quickly, doesn’t seem to demand a great deal of concern at this point. Looking back again to 1995–1996, the markets seemed to agree, with only a small hit during the second phase of the shutdown.

The government funding showdown, though, is just the preview of the main attraction—the debt ceiling debate. Here, the confrontation is much more bitter and the potential consequences much more severe. The state of play right now is that the U.S. hit the debt ceiling months ago, back in May. Since then, the Treasury has been using the “usual extraordinary measures” to shuffle cash around and pay the bills. We’re now approaching the point where the accounting tricks will run out, probably in mid-October. At that point, the Treasury will have to decide whom to pay—and whom not to pay.

The difference between the shutdown and the debt ceiling is this: the shutdown is based on a decision not to spend money we presumably have. The debt ceiling is based on not spending money we don’t have. The fact that, without additional borrowing, we won’t have the money to pay all our bills is what makes the debt ceiling much more consequential. For the U.S. government to run out of money is unprecedented.

We came closest in 2011. In July of that year, when it looked like the government was about to default, the S&P 500 dropped more than 16 percent. Interestingly, interest rates on Treasury bonds actually dropped, from about 3.25 percent to about 2.5 percent. What drove those changes was uncertainty. As I said, although the government has never actually run out of money, the consequences could be extreme, including higher interest rates indefinitely, as U.S. bonds get rerated for the possible risk of default. The stock market dropped in July 2011 to reflect the risk of those consequences.

The fact that interest rates dropped, though, suggests that markets expected bond coupons to continue to be paid even when the government couldn’t pay all the bills. In this, in the short run, I think the markets were right then and would be right now. The government will attempt to minimize the damage of any technical default, to include not actually stopping payments on existing debt—at least for a while.

The sequester provides a good example. Despite all of the predictions of disaster, different agencies managed to handle the spending cuts in a way that minimized the damage. Damage there was, as we have seen in the economy as a whole over the year so far, but it was limited and manageable.

If we get close to a technical default again—and it is a matter of weeks, not months—I would expect the markets to react much as they did in 2011. Stocks could get hit, possibly quite severely, while bonds would take less damage and might even rally. The big difference in the bond market this time, of course, is the involvement of the Federal Reserve.

Should we hit a technical default, I would expect the government to manage the process to minimize, but not eliminate, the damage. Bonds would be paid, social security would be paid—but something would have to be cut.

That is the probability, but not the certainty, and it is the very real possibility of much worse reactions that will keep me focused on the process in Washington. This really is a high-stakes game of poker, with the problem that, no matter who bets, the country as a whole could take the loss.

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